The Tax Court’s decision in YA Global Investments LP v. Commissioner in November sends a warning to the offshore banking, finance and equity investment industries: an offshore entity is engaged in U.S. trade or business when an offshore lender or investor’s agents render substantial, regular and continuous services in the United States.
Those industries are adversely affected by the potential reach of the Tax Court's decision. YA Global, which has already generated much commentary and review, requires that foreign and tax-exempt investors of offshore funds also assess the potential impact of the YA Global decision for funds in place as well as in future business and investment activities.
In the decision, the court held that the taxable income of YA Global Investments, a private venture capital fund resident in the Cayman Islands, for the tax years 2006-2008, was effectively connected income (ECI) of a U.S. trade or business, and, as a flow-through entity, YA Global’s foreign partners were subject to U.S. income tax on their distributive share of such ECI. It necessarily followed that YA Global was obligated to withhold and pay over income tax of its foreign partners at the statutory rate prescribed under Section 1446. This resulted in a $57 million withholding tax assessment to YA Global as determined by the court.
The Tax Court further held that YA Global was engaged in dealing in stocks and securities of its "customers," the U.S. portfolio companies it invested capital in exchange participatory equity positions in the stocks and securities of the companies. It was a “dealer” in its customers securities not a mere investor or a trader. The second holding of "dealer" status subjected YA Global to the mark-to-market rules in Section 475 of the Code which would accelerate reporting of gains (or loss) positions in place and would also result in ordinary income characterization for gains on the sales of stocks and securities of the U.S. portfolio companies. The court further held that the relied upon ECI safe harbor for trading in stocks or securities for one's own account set forth in Section 864(b)(2) was inapplicable. In short, YA Global lost and lost big.
The structure of YA Global's offshore partnership and investment management agreement with a U.S. affiliate is not unusual. In fact, it is a fairly typical structure designed to protect foreign investors and tax-exempt organizations from being subject to U.S. taxation on the investment profits of the fund.
Acting as a "merchant bank" or offshore lender, YA Global provided financing and capital in the form of convertible debentures, convertible preferred stock and notes, to small cap and microcap public companies that had limited access to capital. For the years in issue YA Global was reported to be the biggest venture capital fund of its kind. YA Global did not report to the IRS that it was engaged in a U.S. banking or finance business, despite the extensive activities of its affiliate New Jersey-based investment advisory firm within the United States, Yorkville Advisors, LLC. It did not withhold profits to its "foreign feeder" fund investors. It did not apply the mark-to-market rules, etc. The government challenged the taxpayer's failure to report its income as ECI, failure to withhold under Section 1446, and failure to apply the dealer rules in Section 475. The principal issue in the case was the ECI determination, i.e., whether the activities of an agent under the common law of agency can be attributed to its principal for federal income tax purposes for purposes of applying Section 864(c). The court found in favor of the government on this factual determination which then collapsed the taxpayer's position on all issues.
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